When the facts change....

“When the facts change, I change my mind. What do you do, sir?” - John Maynard Keynes

The above quotation is one of Keynes’ most famous, and is a maxim that Macro Man tries to live by. While it is important not to flip-flop with every incoming piece of information, it is nevertheless vital to investment success not to remain wedded to a preconceived notion when the underlying circumstances change. Many a successful trade has been ruined by failing to recognize a change in circumstance and therefore staying in too long.

A couple of months ago, Macro Man wrote a series of articles on the yen carry trade, or lack thereof. He maintained then, and maintains now, that the size of the yen carry trade is nothing like it was in 1998, and that doomcasts of a similar catastrophic drop are wide of the mark.

That having been said, Macro Man is starting to get a little concerned. While the period immediately after the February G7 saw a flush out of what few legitimate carry trades were out there, the last six or seven weeks has seen a sharp sell-off in the yen against a broad range of currencies. Looking at the yen versus 4 popular carry currencies (USD, NZD, AUD, TRY), it is now weaker in nominal terms against all but the dollar when compared to the point when Macro Man first addressed the subject. In carry-adjusted terms, of course, the yen’s weakness has been even more pronounced.What is different now, compared to a couple of months ago, is that ownership of the carry position seems to be deeper amongst the fund management community. Yen weakness at the end of 2006 and early 2007 was driven, in Macro Man’s view, by Japanese household demand for foreign currency assets. Macro Man would characterize this as an asset allocation shift rather than a carry trade, per se. What’s curious to note is that investment trust sales over the past couple of months have been heavily skewed towards equities rather than foreign bonds/cash plus type products. It seems as if the NZD/JPY uridashi with spot at 88.50 is not terribly appealing to Mrs. Kobayashi. Similarly, one of Macro Man’s favoured flow measures suggests that Japanese institutional selling of yen has yet to re-accelerate in the new fiscal year.

So who or what has driven the yen so weak against high yielding foreign currencies? The answer, it would appear, is that gaijin fund managers have finally and aggressively been sucked into the trade. Macro Man was fairly startled to see the latest Russell/Mellon survey from Deutsche Bank: the median yen position has moved aggressively short over the last couple of months, taking the yen short to its largest in four years.

Source: Deutsche Bank

Coming at a time when risk premia are dwindling to zero, this surely must be a concern. Risky currencies and equities look overbought, though that in and of itself is no guarantee of retracement. The strength of US equities at least might entail an element of short covering; net speculative positions in S&P futures are at levels that kick-started the rally last summer. However, if the yen crosses are similarly overbought and the market is net long...well, the risks of a pullback must surely be significant.

Macro Man is currently short yen in the beta portfolio and more or less flat equity delta, given the short SPM7 calls in the alpha portfolio. On the basis of positioning, at least, he appears to be exposed where he needs protection and flat where the chances of a short covering rally remain. While this doesn’t necessarily require immediate action, Macro Man is now thinking about shifting his hedge profile to fit the evident market positioning.

Thats what am thinking. DXY continues to hover at and around the lifetime lows and is trading very poorly. Am betting on a massive USD selloff for the remainder of this year. Bought 6m 10delta jpy, eur, gbp calls/usd puts this morning. Something tells me these are gonna be very good trades one month down the line.

What's remarkable is how "slow motion" the dollar's sell-off has been. The euro's march higher over the last two months has been fairly steady, almost serene. It's tough to embrace a "crisis" mentality when upside gamma is trading at 7%!

Will dollar weakness continue? It certainly appears that way- for the time being. My view remains that the primary driver of this weakness has been central bank caught overweight dollars, perhaps wrong-footed by the sudden deterioration in the US data in February. I suspect a lot of them thought they could buy their euros on dips below 1.29, were reluctant to chase above 1.30, and then started to panic above 1.34.

Buying tail risk is, I think, an appropriate way to play it, rather than having a massive cash position. With implied volatility so low, the risk/reward is, as you no doubt agree, fairly attractive.

For now, the macroeconomic impact of dollar weakness is likely to be relatively contained. Import prices are more impacted by terms of trade than currencies because of more corporate hedging techniques. As Brad Setser notes, the foreigners buying Treasuries are, for the most part, central banks, so there needn't be the sort of bear steepening fo the curve that oen might usually associate with currency weakness. Something tells me, though, that at 1.40-ish in EUR/USD, it will be worth taking a punt the other way.